Welcome to Parity

Deflation is here. The question before the house: How long it will last?

Ideally, it's just passing through, albeit throwing everyone into a temporary tizzy with worries that the U.S. is set to repeat the Japanese experience. Certainly the Federal Reserve is working overtime trying to make sure the disease is short-lived. But for the moment, at least, prices are generally falling, as we've discussed, including here.

The great experiment in trying to keep a sustained case of deflation at bay is upon us. The immediate danger is that consumers and businesses expect deflation to persist. As many studies have shown over the years, along with more than a fair bit of empirical evidence, expectations are critical factors in determining the level of inflation and its cousin, deflation. Once the Fed loses the battle on managing expectations, monetary policy becomes much weaker.

On that note, we must recognize that one measure of expectations, in the form of market prices for expected inflation, is clearly flashing a warning signal. Expected inflation for the next 10 years, based on the spread between nominal and inflation-indexed 10-year Treasuries, was a mere 0.13%, as of December 26, 2008. That's down from nearly 2.6% in July, as our chart below shows.

click to enlarge

The collapse in inflation expectations is hardly surprising, given what's been going on in recent months and the related descent of interest rates. It would be a miracle if inflation expectations hadn't fallen sharply in the current climate.

From an investment perspective, one might wonder how to think of TIPS vs. conventional Treasuries these days. We can start by recognizing that most of the collapse in inflation expectations is due to the fall in yields on conventional Treasuries. TIPS yields have fallen too, but not nearly as much. The result, as our second chart below reveals, is that something close to parity now prevails for nominal and real (inflation-indexed) yields on Treasuries.

Normally, conventional Treasuries yield more than their inflation-indexed brethren. Why? The extra yield is compensation for exposing one's investment to the ravages of future inflation, if any. Conventional Treasuries only guarantee a nominal yield; TIPS only guarantee an inflation-adjusted yield.

Expecting some level of inflation is the normal state of affairs. Inflation, in the long run, usually dominates, thus the yield premium in conventional Treasuries. But these aren't normal times and so the yield premium for standard Treasuries has shrunk to almost nothing compared with TIPS. And rightly so, if we accept that deflation is the bigger risk at the moment.

In any case, real and nominal yields on 10-year Treasuries are roughly comparable. Buying either security means that you're locking in a yield for the next 10 years of slightly above 2%.

If you expect inflation to one day return, as I do, buying the 10-year TIPS is a no-brainer, since you currently don't have to accept a lower yield relative to conventional Treasuries and at the same time you receive an inflation hedge, effectively at no extra cost. But while running the printing presses at full steam implies that inflation will one day return, perhaps with a vengeance, we can't be absolutely sure about timing or even if higher inflation is fate. We believe it is, but, hey, the future's never fully clear. Meanwhile, some investors and traders are betting that deflation will run on for some time, perhaps longer than expected, and perhaps even for the next 10 years.

Pick your future — and your poison. We don't know which strategy will work out best, but we're supremely confident that one side of this coin will suffer badly. Alternatively, you could hedge the future with a passive allocation to Treasuries and buy an equal mix of nominal and inflation-indexed 10-year Treasuries.

If nothing else, at least we know this: investment choices are just as tough in times of crisis as they are when bull markets are everywhere.

Comments

[GloomBoom.com:]

Inflation is coming. It's only a matter of when. 2010?

2008 Dec 29 04:10 PM

[pitaking:]

I'm glad to finally read someone who can see both sides of this issue. It seems like most "big names" are pounding the table on inflation being the next big bubble but a lot of what I see right now points to deflation. House prices continue to drop, savings rates are climbing for the first time in decades, we are driving less, receiving less credit and only shopping when prices are 50-70% off. The other chart that is worrisome is the free fall in money velocity. Dollars that changed hands constantly aren't moving any more. From banks to buyers to businesses, no one is spending or lending. While inflation will return, I think we are going into a 2-3 year period of deflation based on these signs.

2008 Dec 29 05:18 PM

[MarvinMBA:]

Buying into todays Treasury bond market can tie your money up for years without return or if you need you bucks you will take a big hit. As far as I'm concerned keeping your money close and available in short notice say 90 days or less is the smart way to go without risk of interest rate exposure which is going to burn a lot of long term bond holders...this is the next bubble in my opiinion..MarvinMBA

2008 Dec 29 05:20 PM

[CautiousInv...:]

Recent price action of US Treasury bills, notes and bonds is creating a bubble of sorts.......a result of future price expectations and a flight to safety. The latter can quickly change and when it does there will be downward pressure on prices.

Longer-term, the combined effects of quantitative easing and massive fiscal stimulus is more than likely to change price expectations............. in higher interest rates.

Lastly, there is the issue of how much we must pay foreign investors to assist us with our twin deficits by buying and holding our debt. Given the scale of the stimulus plan and the amount of outstanding debt, I suspect interest rate premiums must increase.

2008 Dec 29 05:30 PM

[Glen Bradford:]

TBT is my play. I'm watching it closely. I don't own it yet, but once these treasuries turn. I'm all aboard. It's double short 20 year treasuries. When this whole thing unwinds, it'll be easy money.

My second idea is for the oil rebound DXO: Still don't own it, but today I really started watching it closely.

Glen Bradford

2008 Dec 29 06:21 PM

[prudentinve...:]

I suspect inflation is coming, and will be high.

Can anyone on this site please enlighten me (and, perhaps enlighten others) about where the demand for treasuries at these ultra-low yields is coming from?

If it is the fed creating money and using it to buying the treasuries, then the ultra-low yields do not reflect the free market's judgment on the issue of inflation vs deflation.

2008 Dec 29 07:15 PM

[Illusional ...:]

I think the fact that the yields on treasuries are that low is a sign that deflation is in progress. The big institutions rather park their money at a loss than take the risk for a bigger profit/loss.

The only thing is how long, which actually depends on what the world leadership does as a whole. One that's solved, inflation will hit. And if the same people that is trying to lead us out of deflation don't react fast enough, inflation will be very ugly. My gut tells me that deflation will be over about 2010, like what gloom said.

2008 Dec 29 07:29 PM

[nmelendez:]

i have a problem with the inflation scenario. If the system was hedged 30:1 and un-leveraged let's say 2 to 1, isn't that a contraction in money supply? To inflate you need to reach the 30:1 or over again before inflation sets in. And with few people going after so many resources, won't that be deflation? Just a thought.

2008 Dec 29 08:06 PM

[Ricard:]

Times like these I wished I owned my own research firm.

I'd ask some simple questions:

1) What is the minimal velocity of money, enough to sustain basic necessities (car/gas for work, shopping at the supermarket/WalMart, rent/mortgage payment)? Once that question is answered, then:

2) Given this minimal velocity, what is the maximum amount of money the Fed would have to print to attain the price stability point emphasized by Bernanke (1.5 - 2%)? This assumes that the Fed will prevent deflation at all costs, which Bernanke has all but said he will do.

3) How close are we to this point?

With this knowledge, I'd try to ascertain if we've hit a bottom. My guess is that such knowledge shouldn't be too hard to attain, given so many articles emphasizing the equation and the Fed's publicly released numbers on money supply. I'd suspect that 1) will consist of a chart to illustrate various levels of "minimal standard" that we are willing to accept.

One could use such information to gauge what the Fed is thinking in this environment (deflation vs inflation), now that the official fund rate is essentially 0. Either that, or just wait for signs that the Fed is about ready to raise rates again, but by that point, the market will probably have already priced in inflation.

2008 Dec 29 08:07 PM

[Ricard:]

BTW, does anyone know of a vehicle that is shorting treasuries and simultaneously loading up on TIPS? This seems like a great long term leveraging strategy using the information in this article. Furthermore it is much, much safter than TBT or PST.

According to Morningstar, PIMCO's PRRDX is doing this to some degree, but does anyone know of a purer play?

Thanks in advance for an enlightening answer.

2008 Dec 29 08:10 PM

[Ricard:]

I think the Fed's solution to this problem is to print enough money to cover the deleveraging. That would subsequently cause massive inflation once any signs of leveraging return to the marketplace.


On Dec 29 08:06 PM [e-mail] wrote:

> i have a problem with the inflation scenario. If the system was hedged
> 30:1 and un-leveraged let's say 2 to 1, isn't that a contraction
> in money supply? To inflate you need to reach the 30:1 or over again
> before inflation sets in. And with few people going after so many
> resources, won't that be deflation? Just a thought.

2008 Dec 29 08:17 PM

[The Last Bo...:]

Pitaking is worried about the decreased velocity and thinks it's a sign of deflation but let's not forget that the equation of velocity has not only a numerator (total transactions*price level) but also a denominator (money supply). The velocity could be slowing down either because the numerator is getting smaller (lower prices and fewer transactions) or because the denominator is getting bigger (too much money). My guess is that all components are changing in the direction that slows the velocity: prices are falling, fewer transactions are executed, and the money press is running non stop.

2008 Dec 29 08:44 PM

[dw57:]

i don't see a real chance of inflation getting out of control inflation. unless some one figures out how to get wages to grow. but with a recession in full swing and no let up yet. and with the last 2 recessions as a guide, jobs won't come back until the recession is spent. and will be at best a luke warm job recovery if the last ones are a guide. otherwise, deflation will reign. because the consumer (AKA employees) incomes are still in the 2001-2002 era.

2008 Dec 29 08:56 PM

[sickofthehype:]

T Bill is a huge bubble. Money supply is insane and growing by the minute. Media will change the masses perception once Obama inaugurated - suddenly you'll hear a positive spin on the economy. Real estate has overshot the downside.

Inflation by Q3 2009. Think 1978.

2008 Dec 29 09:54 PM

[otbricki:]

Japan had no inflation despite its zero interest rates. It is very hard to say what is going to happen here.

2008 Dec 29 10:34 PM

[Romeo Fayette:]

A few effects have unleashed this demand for Treasuries. Remarkably, yields were driven below zero (on the 3-month)!
Why would anyone accept negative yield on an investment; such that an investor/creditor is literally paying the US Treasury to hold onto his money?
Even though the ceiling on FDIC was raised, insurance on a mere $250k is of no consequence for institutions & corporations with millions-to-billions in cash. Before, there wasn't a threat to deposits being vanquished by bank failure. Now, it's a real threat, compounded by a lack of balance sheet transparancy and counterparty risk. The only safe cash equivalent is US Treasury debt. (MMFs break-the-buck!? Most people weren't even aware of that liability. MMFs were CASH INSTRUMENTS/CASH EQUIVALENTS! Is anything sacred?)
Now, we're seeing a crowding out of EM debt as developed economies step-up borrowing and cash flies to the safest haven.
The Fed is not printing money yet. They won't need to monetize their debt while they can cover maturing debt with free ZIRP debt.
The following chart provides evidence of institutional flight from MMFs, etc. Notice the projected plunge in M3:
www.shadowstats.com/ch...


On Dec 29 07:15 PM prudentinvestor wrote:

> I suspect inflation is coming, and will be high.
>
> Can anyone on this site please enlighten me (and, perhaps enlighten
> others) about where the demand for treasuries at these ultra-low
> yields is coming from?
>
> If it is the fed creating money and using it to buying the treasuries,
> then the ultra-low yields do not reflect the free market's judgment
> on the issue of inflation vs deflation.

2008 Dec 30 12:46 AM

[Trace Mayer:]

The current environment is a deflationary credit contraction and the FRN$ system does not so much collapse as evaporate. The last layer to evaporate will be the FRN$ through hyperinflation. When it will happen is anyone's guess though.

www.runtogold.com/2008.../

2008 Dec 30 12:53 AM

[no longer care:]

Are you certain the Fed is not printing money yet? I remember reading this article from the wayback machine...

www.thestar.com/commen...

Where be that haven?

2008 Dec 30 01:46 AM

[Moon Kil Woong:]

he fed is always printing money. The issue is it is going towards productive uses (into the normal economy or into some unproductive usage that makes no goods and services the US citizen needs and thus no real utility for the US economy). Foreign wars are a good example of money not going to meaningful goods and services for Americans while adding to the money supply. This is not a patriotic thing, it's just the simple economic fact. Theoretically if they stay employed in the military when they return maybe we will get some benefit from their increased spending spurring people to make things for them and thus we would have an increase in utility (goods and services increase to satisfy the demand).

Anyway, to make a long story shorter, as long as the Fed keeps sterilizing the money it makes and the Treasury makes by contracting the money supply through 0% interest and increases in Fed deposits through interest on their money real inflation will not occur. And with bankers knowing the bias is towards contraction even if Bernake is yammering about dumping money onto the market in a helecopter, do you think they will believe him?

No they know what game is up. It's called hoard the money game and the banks are very very good at that game. While they play this game, how exactly does money supply grow for all the inflation bulls?

Eventually the cycle will turn, but arguing mass inflation soon is the same as arguing a big recession in 2002. You will pay a hefty penalty waiting for the cycle to turn making the statement essentially wrong (although in reality your statement was just untimely by a few years).

2008 Dec 30 02:15 AM

[Romeo Fayette:]

Yes, I'm certain the Fed has yet to monetize debt to any material effect by printing money, and I'm certain that safe haven "be" in Treasuries right now. Your article provides no evidence of the contrary: "I THINK [my emphasis] the only answer can be that the U.S. Treasury is printing its way out of the current mess."
Note also that your article says the announcement of the Treasury's program to provide the Fed balance sheet aid was immediately ensued by the auction of a $40b 35-day cash management bill. Unless the Fed is the one buying that $40b debt--of which the Treasury forwards the cash proceeds to the public sector--that isn't printing money.
In fact, the Treasury's providing balance sheet bolstering to the Fed pulls M1 out of the system. Issuing $40b in ST debt probably finances that bolstering effort, while taking advantage of sub 50bp front-end yields. Yes, it was the week of that $40b 9/19/08 auction that 1-mo yields first dropped below 100bps.
Also, since the publication of that article (3-1/2 months ago), gold has consolidated while Treasuries have pushed even higher.
With all this liquidity being pumped into the system by the Fed, 'where's the inflation?' you ask. Well, M1 has exploded, but it's offset by the implosion of M3 (see my prior post's link).
Finally, precious metals may not break this consolidation until the inflation/deflation expectation is settled. For the past few weeks, 10-yr TIPS yield have mimicked actual Treasury yields. That's indicative of a zero-inflation expectation.
Yeah, I'm certain.


On Dec 30 01:46 AM Nothing from nothing wrote:

> Are you certain the Fed is not printing money yet? I remember reading
> this article from the wayback machine...
>
> www.thestar.com/commen...
>
> Where be that haven?

2008 Dec 31 01:01 AM

[Moon Kil Woong:]

Very accurate Hardball 22. A trillion here and there doesn't make up for tens of trillions of deflationary money destruction.

2008 Dec 31 01:51 AM

[scotty1560:]

I thought the recent equities and real estate bubbles were a scam created through
derivatives and "0" percent financing among other well thought of treats approved
by our leaders. Uncle Al kept his end of the bargain up with low rates and the
chiefs all got themselves a bigger "crib" and lots of perks.

So maybe the few bucks Hank and Bernie are tossing around won't change the
equation if banks or securities are "responsible". So maybe the inflation hits
the last man standing, the taxpayer. Higher costs of living, higher energy,
added forms of direct or indirect taxation. Maybe assets go sideways for years
circa 70's style stagflation.

I'm not sold on inflationary assets anytime soon, unless we go back
to selling 700k homes to "fruit pickers", then all bets are off. I say
leverage is what created the beast and that's easy to control..if they
really want to..that's where our "advanced" economy has led us to.

Reserve requirements would be appreciated and maybe the 20%
equity rule- not sexy but solves a lot of problems later. Me thinks
we are stuck in the mud for years to come.

2008 Dec 31 02:08 AM